11 July 2023
“Recessions are periods when the economy goes on a diet,” Economist Paul Samuelson.
In normal economic cycles, central banks raise interest rates in response to high inflation, a tight labour market and easy financial conditions, essentially the reality we see all around us. The central banks’ tightening of policy is meant to cool the economy and prevent an overheating that worsens the eventual recession. However, since the 2008 financial crisis, central banks have been reluctant to trigger a recession and have become very nervous about tightening policy and taking interest rates into truly activity-dampening territory.
The market believes that the Fed has done enough with its 500 basis points of hikes, but the reality is that in most economic cycles, the Fed Funds rate needs to at least match the nominal GDP growth rate in order to slow down economic activity enough to take the pressure off both inflation and a tight labor market. As of Q1 data, US GDP was growing at a nominal rate of 720 basis points year-on-year, suggesting that Fed policy is not tight, but neutral at best.
It seems that the dual mandate of price stability and full employment has been replaced with a number one priority of no recession ever, or in Samuelson’s metaphor quoted at the head of this article, “No diet!”
After the COVID-19 pandemic, many people believe that the economy is returning to a normal path. They believe that low interest rates will continue to support growth and that a “soft landing” is possible. However, this view is naive. The economy is currently loaded with excess debt and asset valuations are at all-time highs. A “soft landing” is very unlikely in this environment and, as an economic concept, is extremely rare!
The global economy is currently more like a river that has been dammed up. The dam represents the various factors that have been holding back economic growth, such as the COVID-19 pandemic, supply chain disruptions and the war in Ukraine.
As these factors start to dissipate, the dam will begin to break and the river will flow more freely. This will lead to an extension and resurgence of economic growth and inflation, contrary to the prevailing consensus of an imminent recession together with a credit crunch and housing crisis. The freeing of obstacles will allow the overall economy to steer clear of a deep recession and possibly a minor recession, even in real GDP terms.
This means that the Fed and the economy will have a run rate in nominal GDP terms that is higher than expected. There is ample pent-up demand at state levels, company levels, and from the IRA (the Inflation Reduction Act) and the CHIPS and Science Act to keep employment firm.
An insufficiently restrictive policy backdrop has set up a potential bubble in the stock market. The valuation this year has been driven by three impulses: the Silicon Valley Bank and regional bank mini-crisis, the trouble lifting the debt ceiling, and the super-valuation of the sub-set of mega caps and large cap stocks most associated with the introduction of generative AI applications (OpenAI’s ChatGPT and Google’s Bard).
The first two created a liquidity injection of more than $1 billion. The third became the driver of super-exponential prices for the most directly AI-linked names. The hype surrounding AI is the chief driver of the latest stock market surge, with talks of this being a new iPhone moment or even akin to the introduction of the internet. This is not a knock on AI, as we are keenly aware of the potential for generative AI to increase productivity over time. But the market is getting ahead of itself in selecting winners, and current valuations are already discounting too much of the longer-term future gains to be had.
The surface of this economic sea may be calm, with volatility at extremely low levels. However, beneath the waterline, there are strong currents and countercurrents, which, to our minds, set up a difficult second half of 2023.
We don’t have the ability to time and project where the markets are going, but we do have the ability to recognise when a bubble is forming and where data doesn’t support the narrative. This bubble, and all bubbles, are accelerating when the fundamentals don’t support the narrative.
The good news is that a deep recession is unlikely to happen. The bad news is that interest rates will need to stay high for longer. We simply don’t think the “audio matches the video” looking at complacent market expectations versus the likely path from here.
Steen Jakobsen, CIO